Of Chinese bondage

Would you like bonds with that?

McDonald’s image is very much burgers and fries rather than financial innovation. But the American fast food chain tested new water last week, when it became the first foreign company outside the financial sector to issue a renminbi-denominated bond in Hong Kong.

Admittedly the company abstained from super-sizing the deal – just Rmb200 million ($29 million) worth of notes were issued. What is of more interest are the terms of the deal: the three-year bond comes with a 3% coupon.

To put this into perspective, last month McDonald’s issued $750 million worth of notes that will pay 3.5% annually, the lowest coupon paid by any US company to borrow dollars for at least 15 years, reports the Wall Street Journal. So the terms in China look competitive. Other corporates could be attracted to the renminbi bond market as a source of cheap credit.

And investors have reason to be interested too. Hong Kong has become something of an offshore hub for the renminbi, as investors stock up to profit from anticipated currency appreciation. With interest rates on renminbi deposits low, the bonds offer an opportunity for better returns.

Paradoxically an appreciating currency could be a key factor that stops many foreign companies from tapping the market. “Owing debt in yuan means you’ll have to pay back even more when it’s due,” a Hong Kong-based economist told Reuters, “and that’s not a good thing when you don’t even know how much it’s going to appreciate by.”

Companies with substantial revenues in renminbi (also called the yuan) can avoid this problem. But there are other challenges that could hinder offshore renminbi-denominated bonds. For a start, there can be bureaucratic obstacles to transferring renminbi to and from mainland China. Furthermore, the amount of renminbi-deposits in Hong Kong is still small (as of June, they totalled Rmb89.7 billion), which means that issuers have only a limited pool of cash to tap.

While the interest of foreign companies in issuing renminbi-bonds in Hong Kong is another reminder of the gradual internationalisation of the Chinese currency, many big investors are paying greater attention to the bond market inside China itself. As the Asia head of fixed-income at MFC Global Investment Management (MFC GIM) recently told AsianInvestor Magazine, “China is the most exciting fixed-income market in Asia, and possibly the world.”

At the end of last year, China’s bond market was worth $2.4 trillion, up from just $62 billion in 1996, according to the Asian Development Bank. Although it now accounts for more than half of bonds issued in Asia ex-Japan, the weighting of issuance is heavily skewed towards local governments and financial companies. Corporate bonds account for only 15% of the market.

Companies are still expected to turn more towards debt capital markets for funds. “Looking ahead, we would expect non-bank corporates to show the fastest growth, though this growth is off a low, or rather non-existent base,” one investor told AsianInvestor.

As China’s corporate bond market finally comes of age, foreign investors are starting to see it as a realistic alternative to the A-share market. Funds are already being committed: MFC GIM has allocated 30% of its $200 million qualified foreign institutional investor (QFII) quota to its renminbi bond fund, and Aberdeen Asset Management intends to put most of its forthcoming QFII quota towards the bond market, reports AsianInvestor.

The growth of the bond market should benefit the corporate sector, since it provides an alternative to bank loans, which have traditionally been the most common source of capital.

The main problem with this is that banks are most interested in lending to the largest companies, especially state-owned enterprises. Not only are these big borrowers the most profitable clients, they require less in the form of credit checks than their smaller counterparts. The result is that small and medium-size enterprises often find it difficult to secure funding from the banks. A more active bond market could change that.

Bonds should be attractive to companies, both large and small. They have a fixed interest rate throughout their duration, whereas bank loans fluctuate in line with central bank’s lending rates. By issuing a bond, the company knows exactly how much it has to pay up until it reaches maturity.

This all suggests that China is beginning a more fundamental shift in how its companies source capital. Most welcome the transition, although there is a school of thought that believes that the rise of the bond market could lead to disaster.

The nightmare scenario is as follows. As the bond market grows, companies will borrow less from banks. As loan books shrink, banks find themselves less profitable, and therefore face the need to grow share in new markets. If companies have become less inclined to borrow, that may mean that the banks chase consumers with loan offers instead. Increased consumer access to credit – alongside other factors such as an appreciating currency – could then lead to asset inflation, in everything from the stock market to housing prices. This cycle of borrowing and spending will continue, pushing prices upwards, until the next bubble bursts.

It may be a gloomy theory, but it has a precedent: Japan in the 1980s. China’s neighbour went through a similar process before its bubble economy collapsed in 1991, an event from which it is still to mount a full recovery.

The development of China’s bond market might be a natural development of its financial system, but the government would be wise to keep the Japanese experience in mind.

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